When calculating WACC, why is the term (1-tax rate) included for debt?

The inclusion of the term (1-tax rate) in the calculation of the Weighted Average Cost of Capital (WACC) for debt reflects the after-tax cost of debt. This is because interest on debt is generally tax-deductible for corporations, meaning that the effective cost of borrowing is reduced by the tax shield provided by that deduction.

When a company pays interest on its debt, it reduces its taxable income, which lowers the actual cash cost of that debt. For example, if a company has a nominal interest rate of 6% and operates in a jurisdiction with a 30% tax rate, the after-tax cost of debt would be calculated as 6% * (1 - 0.30) = 4.2%. Therefore, using the after-tax cost of debt in the WACC calculation provides a more accurate reflection of the actual cost of financing that the company faces, as it accounts for the benefits provided by tax deductions.

This adjustment is crucial for investors and analysts when evaluating a company's overall cost of capital, as it ensures that the calculations reflect the true cost that affects the company's net income and its valuation.